Tue 18 Dec 2007
We’d all love to find the best money manager in the world. How convenient – just turn over your bucks, and watch the investment magic unfold!
Many clients ask me hopefully about getting into that situation. Whenever they look at investment managers, the first question they usually ask is, “What’s his/her track record?” Investors view this as vitally important: surely if a manager has delivered in the past, money will also be forthcoming in the future.
To such clients, I have to break the news gently: a good track record may be useful, or it may not. Consider the following long-term trend: I personally have been alive for the past 48 years. But does that fact offer any meaningful prediction for the future? Does a 48 year trend mean that I am going to live forever?
Or suppose that beef cattle had the same intelligence as the writer of an investment newsletter. One steer might say to another: “The farmer has a wonderful track record: every day he shows up with a bale of hay for me!”
Or imagine an extreme sport involving wooden barrels and Niagara Falls. Let’s say a hundred people climb into barrels and plunge repeatedly over the mighty falls. From the first plunge, thirty survive; from the second, ten; and from the third ride, only two. Clearly, those final two must have a great track record for riding Niagara Falls in a barrel – right?
These examples illustrate two major problems with relying on past performance to predict the future. The first is that you can easily draw the wrong conclusion from the evidence. That regular bale of hay may make the steer assume for quite a while that the farmer really cares for his well-being. But if we follow the story to the end, we can guess this particular trend will take a dramatic twist.
The second problem is that track records often contain random elements: the pattern may look regular, but in fact it represents a chaotic and unpredictable series. The results of those (thankfully imaginary) trips over Niagara Falls may suggest a certain order, yet in the end they’re merely random events.
Here’s a cautionary tale from a decade ago. Back in 1998, an investment firm called Long-Term Capital Management almost melted down the world’s financial system. Their error was to assume that fixed income variables would remain within certain parameters. They borrowed massive amounts of Russian and Latin bonds, selling U.S. Treasuries short to cover these purchases.
Sadly, the bottom fell out of their assumptions: first the Russians unceremoniously defaulted on their bonds, and then the Latin American bonds went into a tailspin. The fact that this supposedly should never have happened, according to all existing track records, was cold comfort to the investors who lost billions.
Alas, the Wall Street players did not learn their lesson very well. At this very moment, a very similar disruption – the sub-prime mortgage crisis – is stripping billions out of investment firms, banks, hedge funds, and the accounts of many investors. Again, this came about because those responsible relied on a past track record, and assumed that mortgage default rates would remain constant. Today, the refrain in boardrooms across the nation is: “We looked at the past data, this really should not have happened!”
The lesson we should all learn from this? Most people need expert help with their finances; but when we look for that help, we shouldn’t put too much trust in their track records.
True, the past performance of a particular manager may say something about his or her future performance. Still, you may want to use a few more important criteria, such as industry experience, professional accreditation, and personal references from other satisfied clients.
When it comes to investing your life’s savings with a financial advisor, just try asking this question: “Do you really know what will happen next year?” Listen carefully to the answer. In a nutshell, anybody who claims to know what will happen in the coming year is offering you barrel driving lessons.
Alan MacDonald is an investment advisor who helps high tech entrepreneurs make smart decisions about money. Contact Alan at Alan.Macdonald@RichardsonGMP.com
Alan MacDonald CFA CFP
Ph: 613-788-8010
Cell: 613-863-5343
Fax: 613-788-8078
343 Preston St. Suite 300
Ottawa, Ontario K1S 1N4